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What Is A Factoring Agreement
A factoring agreement is a type of financing agreement where a company obtains a certain amount of cash using its current invoices and accounts receivables.
In other words, a factoring agreement is a contract where a small business or company sells its outstanding invoices to a third party (the factor) in exchange for cash upfront.
Eventually, when the invoices are settled by the company’s clients, the factor will collect the account receivables allowing them to make a profit on the money they collect versus the cash they pay out to the company upfront.
Understanding Factoring Agreements
Factoring companies make money by purchasing your accounts receivables at a discount.
For example, if you have $100,000 of accounts receivables, the factoring company will pay you $65,000 or $70,000 to acquire the right to collect $100,000 of your accounts receivables.
You will have to pay a factoring fee when doing business with a factor.
The fees you’ll pay will depend on your industry, how much receivables you are factoring, the creditworthiness of your clients, and how many days your receivables are outstanding, among other factors.
Factoring Agreement Definition
How do you define a factoring agreement?
A factoring agreement is a contract where companies sell their outstanding invoices turning them into cash allowing them to fund their working capital.
Companies will use factoring companies to access the cash for urgent business needs instead of waiting weeks, or months, for their clients to pay their invoices in the normal course of business.
Factoring Arrangement Benefits And Drawbacks
The main benefit in a factoring arrangement for a company is that it can immediately access liquidity to fund its short-term needs by using its unpaid invoices.
There are different situations where a company’s short-term cash flow requirements exceed its working capital and the amount of money it has available.
One way to obtain financing, the company can use the outstanding invoices on its books to get the cash it needs to maintain its cash flow.
A company can enter into a factoring agreement to fund business growth, solve short-term working capital crunches, maintain inventory, or fund an unexpected expense.
Although factoring agreements can be an interesting way of obtaining financing outside the traditional means, they do have drawbacks.
The first important drawback to consider is that you will need to cover the costs of factoring, pay for the account maintenance, and other legal fees.
As a result, the factoring costs can be significantly higher than more traditional means of financing.
The second drawback is that since you are factoring your accounts receivables and receiving all the liquidity upfront, your revenues will be lower in the long run.
The third drawback is that factoring agreements can get complicated for small businesses to understand and process at times.
You may need to pay a qualified attorney to explain to you the details of the contract so you don’t get caught with hidden fees or costs that you did not anticipate.
Key Accounts Receivable Factoring Agreement Terms
What are the key terms that you may find in a factoring contract?
A factoring contract can get quite complicated.
It’s important to understand the key terms of factoring contracts to ensure that you understand what rights you are giving up along with the fees that you’ll assume.
To help you in this process, here are some key terms that you should be mindful of.
Read your accounts receivables factoring agreement to make sure you understand all the upfront fees that you will be asked to pay.
Typically, factors will ask for a small percentage as originating fees.
Another area that you should consider is how much will it cost you if you wanted to end your factoring agreement?
Will you have termination fees?
In general, factoring contracts have a term of one to three years with automatic renewals.
Factoring companies will generally charge you a termination fee if you decide to end your agreement early, so pay attention to that.
Verify if your factoring company is asking you to pay weekly or monthly fees.
Depending on the company you may deal with, some will ask for an ongoing fee during the process that your contract is in effect.
Factoring companies will provide cash in exchange for your accounts receivables.
However, if most of your accounts receivables are linked to one or a few customers, they will not fund the entire amount.
Factoring companies will want to reduce their risk exposure by capping how much they finance you for invoices linked to one customer.
In most factoring agreements, factors will require that companies provide security interest on their assets to secure their obligations.
When your company is not requesting any advances from the factor, the lien will be registered against your company’s accounts receivables, the amounts standing to your company’s credit with the factor, and other assets linked to your accounts receivables.
When you ask for an advance from the factor, the lien will include personal property such as inventory, intellectual property, or other personal assets that the factor can realize in the event of default.
Companies that sell the accounts receivables to factoring companies will have the obligation to inform their clients that they have sold the invoice.
The company must also direct its customers to pay the factoring company directly as opposed to the business.
Make sure you read the contract to understand your obligations relating to the notifications you must provide your clients along with any ongoing updates on your accounts receivables.
To be in business, factoring companies must carefully assess the risk associated with your clients and the invoices you are selling.
Factoring companies will generally have the right to refuse a specific client as the client is not creditworthy or has the potential of exposing the factoring company to too much risk.
Be sure to read the contractual mechanism for factoring companies to disapprove invoices from a client of yours and how you can resolve disputes in case you do not agree with their assessment.
You want to pay close attention to the default triggers in your factoring arrangement.
What are the events that your factoring company considers as events of default triggering termination rights, rights to claim fees and damages, and other rights granted to the factor in the event of default?
Make sure you are comfortable with the default triggers so that you avoid getting into trouble shortly after signing your contract.
Factoring Agreement Steps
When you engage a factoring company to sell your accounts receivables in exchange for some cash, what is the process?
The first step is for you to receive a proposal letter from the factoring company.
In the proposal letter, you will typically find the commercial terms offered by the factoring company.
Once you negotiate and agree with the terms of the proposal, you will need to sign that document to formally start the contracting process.
You will also be asked to provide a deposit.
Once the proposal letter is signed and the deposit paid, you will receive the draft factoring agreement from the factor, personal guarantee document, Secretary or Manager’s Certificate depending on the nature of your business, draft notice to your clients, and other related documents.
When the terms and conditions of these documents are duly negotiated and agreed upon, you will sign the factoring agreement along with the related documents.
Finally, once all the documents are properly signed, the factoring company will pay you the purchase price and you will then need to give your notice to your customers and start managing your accounts receivables as per the terms of the factoring contract.
Tips When Entering Into A Factoring Contract
Like any financing agreement you sign with a financial institution or lender, it’s important to understand the terms of the contract, its benefits, and its impact on your business.
Here are some tips when contract factoring.
Read The Contract
As with any contract, it’s your duty to read the contract, ask questions, and make sure you understand what you’re getting into.
Factoring contracts can get quite technical and so you may want to bring the right people to help you negotiate and sign the agreement.
Your Customer Relationship
When you do business with a factor, you have to be mindful of the fact that you will eventually need to tell your customers about it.
Also, the factoring company will have a direct line of communication with your clients.
It’s important you manage your customers’ expectations and how they perceive your business when they become aware that you sold their invoice.
You don’t want to hurt your customer relationships and you want to make sure the factoring company does not adversely impact your book of clients.
Your Finacial Obligations
Probably the most important element to consider when signing with a factoring company is to know, with great precision, how much the whole thing will cost you.
Make sure you know what are the fees that are charged upfront, on the backend, and on an ongoing basis.
In addition to the fees that you’ll need to pay the factoring company, you should also calculate how much the transaction will cost you (for example, paying a lawyer to review the contract, etc).
Factoring Agreements Takeaways
So there you have it folks!
What Are Factoring Agreements
A factoring agreement is a contract that you’ll enter into with a factor who purchases your accounts receivables, collects on those accounts, and pays you a lump sum upfront.
Accounts receivable factor, also just known as factoring, is a financial transaction where a company purchases your accounts receivables at a discount in exchange for paying you a sum of money upfront.
The main objective of doing business with factoring companies is to free up capital that is tied up to your accounts receivable, transfer some of your accounts receivable risk to a third party, and access cash immediately instead of waiting for the duration of your client’s credit term.
Now that you know what is a factoring agreement, the factoring process, why companies sell their receivables, and its advantages and disadvantages, good luck with your research and funding!
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